Foreclosure Nation

The mortgage foreclosure crisis is a big, huge, complicated mess affecting millions of homeowners throughout the country. A group of professors from the Law School and Business School are working from multiple angles to help turn the tide.

The news from the housing market continues to be bad. Home prices have yet to hit bottom, leaving too many people in homes they cannot afford. Some 10 percent of homeowners are delinquent on their mortgages, and roughly 250,000 begin the foreclosure process each month. Yet that process is slow and brutal, and regulators have been investigating “robosigning” and other foreclosure irregularities by the banks. Meanwhile, the Obama administration’s signature housing program has failed to live up to its expectations, leading opponents to call for its end.

This real-world housing crisis has made Edward R. Morrison and Christopher J. Mayer, experts on once-arcane topics like bankruptcy and mortgages, hot commodities in Washington, D.C. Morrison, the Harvey R. Miller Professor of Law and Economics and Co-Director of the Richard Paul Richman Center for Business, Law, and Public Policy, and Mayer, the Business School’s Paul Milstein Professor of Real Estate and Senior Vice Dean, have testified before Congress four times about the nation’s mortgage foreclosure mess.

In presentations before various committees of the House and the Senate between November 2008 and February 2009, Morrison and Mayer laid out a plan for helping up to 1.5 million homeowners out of financial distress. Rather than modifying mortgages in bankruptcy courts, they argued for using financial incentives and legal “safe harbor” provisions to entice mortgage servicers to modify loans that had gone bad. Their theory, in brief, was that the rise of securitization had hampered modifications even when it was in the interest of lenders (and investors), as well as borrowers. “We were attracted to approaches that could be rolled out more quickly, and where the mortgage servicers could handle the modifications rather than the judges,” Morrison says.

What happened in the months and years following that testimony has served only to confirm what Morrison and Mayer already knew: The mortgage crisis is a complicated, layered problem, with no easy answers or simple solutions.

In March 2009, the Treasury Department unveiled a $75 billion federal Home Affordable Modification Program (known by its acronym, HAMP) that incorporated portions of Morrison and Mayer’s proposal. Since then, nearly 1.5 million homeowners have entered trial modification under HAMP, according to the administration’s latest statistics. But with millions more homeowners delinquent and at risk of foreclosure, the program has been criticized sharply for not doing enough: Not only have modifications been slow to proceed, but many who started the trial process got weeded out of the program. Others who were awarded permanent modification ended up re-defaulting.

The Congressional Oversight Panel now estimates that HAMP will prevent fewer than 800,000 homeowners from going into foreclosure, a fraction of the government’s initial estimates of 3 to 4 million. “[D]espite the apparent strength of HAMP’s economic logic, the program has failed to help the vast majority of homeowners facing foreclosure,” according to the panel’s December report.

Expectations for HAMP were set unrealistically high, Mayer argues, and its results are in line with his and Morrison’s forecasts. “This was never going to be a silver bullet,” Mayer says. “The program failed by comparison to the target, but that was not a realistic target.”

In hindsight, the mortgage crisis seems almost inevitable. Home prices increased rapidly. Banks gave out mortgages like candy. Then those mortgages were sliced and diced, and packaged into securities for sale to investors. Lending to subprime borrowers soared, as did the number of borrowers who signed adjustable-rate mortgages on the theory that home prices could only go up.

Only in retrospect did most realize it was a bubble. When the economy soured and housing prices dropped, many homeowners who had bought at inflated values were stuck in homes they could no longer afford, with debts larger than their properties’ value. As a result, over the past two years, some 3 million foreclosures took place, and the Federal Reserve has estimated that another 4.25 million homeowners will go into the foreclosure process by the end of 2012.

With 50 million mortgage-holders in the United States, and about one-quarter of them at risk of default because they owe more on their mortgages than their homes are worth, there’s a particular urgency to come up with the right answers. “The biggest problem may be yet to come,” says Business School Assistant Professor Tomasz Piskorski, who joined with Edward Morrison and Christopher Mayer to co-author the mortgage modification paper they presented to members of Congress.

In devising good policy, understanding the behavior of lenders and borrowers alike is key to avoiding unintended consequences. “Almost all of our work has been looking at what motivates homeowners’ decisions with respect to paying their mortgages or walking away from their homes,” Morrison says.

In their second paper together, Morrison, Mayer, and Piskorski looked at whether borrowers exploit the mortgage modification process by going into default specifically to qualify for aid. As a proxy for government data, the professors analyzed what happened when Countrywide Financial (which had been purchased by Bank of America in 2008) announced in October 2008 a nationwide mortgage modification program scheduled to begin in December of that year as part of a settlement agreement. The result: In just a few months, a large number of borrowers stopped paying their loans in order to qualify for the program. “We found good evidence that the settlement caused a 13 percent to 20 percent increase in delinquencies immediately after it was announced,” Morrison says. “Whether that’s a large or small number is the big question now.” Interestingly, the strongest response came from people who had a lot of borrowing capacity on their credit cards and seemed least likely to default in the near term.

The Countrywide results illustrate the balancing act any government program faces in trying to help borrowers headed for foreclosure. Administrators must make sure not to spend precious taxpayer dollars on programs that bail out those who would otherwise be able to pay their debts on their own. “It’s very difficult to know who needs government help,” Morrison says.

The professors currently are examining the extent to which foreclosure rates are impacted by whether mortgages are recourse loans that allow lenders to go after borrowers for the full amounts they owe—preliminary research shows that it matters less than people think, according to Morrison—and whether defaults and foreclosures create contagion that can spread through communities. Working within the new Richard Paul Richman Center for Business, Law, and Public Policy, Morrison and Mayer hope to mobilize researchers across disciplines to find solutions to the housing crisis and other public policy issues. “A lot of policy work is driven by ideology,” Morrison says. “We will provide problem-focused research that’s driven
by facts.”

As that longer-term research moves forward, Morrison and Mayer point to fixes that can be made now. In an op-ed published by The New York Times this past September, Mayer and R. Glenn Hubbard, dean of the Business School, proposed that the government facilitate refinancing for homeowners who are “underwater” and living in homes that are worth less than the mortgages on them. If these homeowners could refinance at current, lower interest rates—something they typically cannot do because their homes are worth less than their loans—many families would see their mortgage payments decrease, thus increasing their ability to make payments.

This is “low-hanging fruit that the administration has not yet done anything about,” Mayer says. “The great thing is that this program would come at no cost to taxpayers. We haven’t yet taken advantage of a great opportunity to help people lower their mortgage rates.”

Another proposition, but one that addresses the situation where so many home-
owners are underwater, is the idea of devising government-aided modifications that do more to cut principal balances. Professor Ronald Mann argues that more substantial solutions, including cutting principal balances, are necessary. “With respect to the mortgage part of the crisis, nothing is working at all,” Mann says. “There is a real fear of modifying loans down to the real value of the homes. But we were in a bubble—the prices of 2008 were not the real numbers. So as long as you have a large amount of the American populace sitting in homes with loans far higher than they will ever be worth, and the lenders can’t modify, eventually all these people have to get through the foreclosure system, and that is going to take a long time.”

If homeowners receive mortgage modifications that keep their debts too high compared with the value of their homes, they are likely to default again. What must be avoided, Morrison argues, is a situation where the modification programs nudge too many people to show up for aid, and the interest-rate reductions they receive are not enough to stem the tide of foreclosures. “That’s the nightmare scenario,” he adds. “It suggests that you could have a better-designed policy—programs that decrease principal balances.”

Even if more homeowners can get their mortgages modified, the reality is that some will still need to go through foreclosure. And that process, right now, appears to be too slow, unwieldy, and rife with problems. “A foreclosure system that was swift and certain, and moved houses through the process quickly when the loan is not being paid, would move us through the crisis more quickly,” Ronald Mann says. “Time is just a deadweight loss.”

The key going forward may be balancing speed concerns with cost-related issues. If cost were no object, Tomasz Piskorski notes, you could simply wipe out everyone’s debts. “The question is not whether we can design a solution to foreclosures,” he says. “The question is how to do it in a way that is not too expensive.” If President Obama went on TV tomorrow and announced a program for every borrower who misses a payment, a lot of people would default just to qualify, Piskorski adds, and the cost to taxpayers would be massive. “It would redistribute a lot of wealth from people who are responsible about saving and to people who took on a lot of housing debt,” he says. On the other hand, as Edward Morrison says, there are benefits to speed when millions of mortgage holders are delinquent. “Early rescues are more valuable than late ones,” he says. “They can prevent foreclosures from spiraling out of control. The longer we wait, the more costly it becomes to stop the housing crisis.”

Amy Feldman has written for The New York Times, Money, and Time, among other publications.